Corporate-Financing-and-Investment-Decisions-When-

NBERWORKINGPAPERSERIESCORPORATEFINANCINGANDINVESTMENTDECISIONSWHENFIRMSHAVEINFORMATIONTHEINVESTORSDONOTHAVEStewartC.MyersNicholasS.MajiufWorkingPaperNo.1396NATIONALBUREAUOFECONOMICRESEARCH1050MassachusettsAvenueCambridge,MA02138July19814TheresearchreportedhereispartoftheNBER'sresearchprograminFinancialMarketsandMonetaryEconomics.AnyopinionsexpressedarethoseoftheauthorsandnotthoseoftheNationalBureauofEconomicResearch.NBERWorkingPaper#1396July1984CorporateFinancingandInvestmentDecisionsWhenFirmsHaveInformationThatInvestorsDoNotHaveABSTRACTThispaperconsidersafirmthatmustissuecommonstocktoraisecashtoundertakeavaluableinvestmentopportunity.Managementisassumedtoknowmoreaboutthefirm'svaluethanpotentialinvestors.Investorsinterpretthefirm'sactionsrationally.Anequilibriummodeloftheissue-investdecisionisdevelopedundertheseassumptions.Themodelshowsthatfirmsmayrefusetoissuestock,andthereforemaypassupvaluableinvestmentopportunities.Themodelsuggestsexplana-tionsforseveralaspectsofcorporatefinancingbehavior,includingthetendencytorelyoninternalsourcesoffunds,andtopreferdebttoequityifexternalfinancingisrequired.Extensionsandapplicationsofthemodelarediscussed.StewartC.MyersFinanceSectionSloanSchoolofManagementM.I.T.50MemorialDriveCambridge,MA02139NicholasS.MajlufDepto.IngeleriadeSistemasPontificia(UniversidadCatolicadeChile)VicunaMackenna4860Staniago,Chile—3—CORPORATEFINANCINGANDINVESTMENTDECISIONSWHENFIRMSHAVEINFORMATIONTHATINVESTORSDONOTHAVEStewartC.MyersandNicholasS.Majluf1Considerafirmthathasassetsinplaceandalsoavaluablerealinvestmentopportunity.However,ithastoissuecommonsharestoraisepartorallofthecashrequiredtoundertaketheinvestmentproject.Ifitdoesnotlaunchtheprojectpromptly,theopportunitywillevaporate.Thereareotaxes,transactioncostsorothercapitalmarketimperfections.Financetheorywouldadvisethisfirmtoevaluatetheinvestmentopportunityasifitalreadyhadplentyofcashonhand.Inanefficientcapitalmarket,securitiescanalwaysbesoldatafairprice;thenetpresentvalueofsellingsecuritiesisalwayszero,becausethecashraisedexactlybalancesthepresentvalueoftheliabilitycreated.Thus,thedecisionruleis:takeeverypositive—NPVproject,regardlessofwhetherinternalorexternalfundsareusedtopayforit.Whatifthefirm'smanagersknowmoreaboutthevalueofitsassetsandopportunitiesthanoutsideinvestorsdo?Aswewillshow,nothingfundamentalischangedsolongasmanagersinvestineveryprojecttheyknowtohavepositiveNPV.Iftheydothis,thesharesinvestorsbuywillbecorrectlypricedonaverage,althoughaparticularissuewillbeoverorunderpriced.Themanager'sinsideinformationcreatesasidebetbetweenoldandnewstockholders,buttheequilibriumissuepriceisunaffected.However,ifmanagershaveinsideinformationtheremustbesomecasesinwhichthatinformationissofavorablethatmanagement,ifitactsintheinterestoftheoldstockholders,willrefusetoissuesharesevenifitmeans—4—passingupagoodinvestmentopportunity.Thatis,thecosttooldshareholdersofissuingsharesatabargainpricemayoutweightheproject'sNPV.Thispossibilitymakestheprobleminteresting:investors,awareoftheirrelativeignorance,willreasonthatadecisionnottoissuesharessignalsgoodnews.ThenewsconveyedbyanIssueisbadoratleastlessgood.Thisaffectsthepriceinvestorsarewillingtopayfortheissue,whichinturn,affectstheissue—investmentdecision.Ifthefirmfinallydecidesnottoissueandthereforenottoinvest—andwewillshowformallyhowthiscanhappen——realcapitalinvestmentIsmisallocatedandfirmvaluereduced.Ofcourse,wewouldalsoexpectmanagementtotrytorearrangethefirm'scapitalstructuretoavoidbeingcaughtinthisfinancingtrapthenexttimethefirmhasapositive—NPVinvestment.Thus,ouranalysisofhowasymmetricinformationaffectsfirm'sIssue—Investmentdecisionsmayleadustoexplainsomecorporatefinancingchoicesasattemptsbyfirmstoavoidtheproblemswehavejustintroduced.Thefirstproblemistofigureouttheequilibriumsharepriceconditionalontheissue—investmentdecision,assumingrationalinvestors,andalsoarationalfirmwhichbasestheissue—investmentdecisiononthepriceitfaces.Thispaperaddressesthatproblem,andsolvesitunderreasonablesimplifyingassumptions.TheassumptionsaresetoutanddiscussedinSection1.Thissectionalsocontainsanumericalexample.AgeneralformulationandsolutionIsgiveninSection2.However,Section2'sresultsraisedeeperissues.Oursolutionassumesthatmanagementactsintheinterestsofold(existing)stockholders.Italsoassumesthosestockholdersarepassive,anddonotadjusttheir—5—portfoliosinresponsetothefirm'sIssue—investdecision,exceptpossLblytobuyapredeterminedfractionofanynewissue.Thisassumptionmakesfinancingmatter.Afirmwithamplefinancialslack——e.g.,largeholdingsofcashormarketablesecurities,ortheabilitytoissuedefault—riskfreedebt——wouldtakeallpositive—NPVopportunities.Thesamefirmwithoutslackwouldpasssómeup.Also,withthisassumptionaboutmanagement'sobjective,ourmodelpredictsfirmswillpreferdebttoequityiftheyneedexternalfunds.Ifoldshareholdersareassumedtobeactive,andtorebalancetheirportfoliosinresponsetowhattheylearnfromthefirm'sactions,thenfinancingdoesnotmatter:financialslackhasnoimpactonInvestmentdecisions.Evenwithampleslack,thefirmwillpassupsomepositive—NPVInvestments.Wecan